Accounting 9. Capital Budgeting Clive Vlieland-Boddy 2009. Consumption of non Current Assets.
Formula: Net Profit/Average investment
Year Project A Project B
1 1,580 280
2 2,080 1,080
3 2,080 1,080
4 80 1,080
5 80 2,580
6 80 1,880
Total Net Profit After Tax 5,980 7,980
Average Annual Net Profit 5,980/6 = 996.6 7,980/6 = 1330
The most difficult issue is firstly establishing exactly what the future cash flows are likely to be. Clearly you know what you will have to pay for the new fixed asset, but what cash flows will it generate and what will be its scrap value.
A company is considering buying a new machine that will cost $100,000 and will generate $15,000 per annum for the next 12 years., then scrapped for $9150.
Assuming that the cost of capital is 6% for a project involving a lump sum cash outflow of $8,200 and annual cash inflows of $2,000 for 5 years, the Net Present Value calculations are as follows:
a) Present value of cash outflows $8,200 in year 0 (NOW)
b) Present value of cash inflows
Present value of an annuity of $1 at 6% for 5 years = $4,212 = $8,424
Net present value = present value of cash inflows - present value of cash
Since the net present value of the project is positive ($224),
PI = Present value on cash inflows
Present value of cash outflows